On January 12, 2018, the U.S. Supreme Court granted certiorari over the Eleventh Circuit’s decision in R. Scott Appling v. Lamar, Archer & Cofrin, LLP, which held that a fraudulent statement regarding a single asset may constitute a statement concerning the debtor’s financial condition, thereby allowing a debt incurred in reliance on the false statement to be discharged through a bankruptcy. The Eleventh Circuit’s decision focused on the dichotomy established in sections 523(a)(2)(A) and (B) of the Bankruptcy Code between fraudulent statements regarding the debtor’s “financial condition,” which only prevent the discharge of a debt if the false statement is made in writing, and other fraudulent statements giving rise to a debt, which can prevent a discharge even if the statement is only made orally. R. Scott Appling v. Lamar, Archer & Cofrin, LLP will allow the Supreme Court to address a split between the Circuits on this issue, as the Eleventh Circuit’s ruling is consistent with the approach adopted by the Fourth Circuit,[1] but contrary to the standard adopted by the Fifth, Eighth, and Tenth Circuit’s approach, which holds that a statement about a single asset does not “respect” a debtor’s financial condition as required by 523(a)(2)(A).[2]

The case arises out of an adversary proceeding initiated by Lamar, Archer & Cofrin, LLP (“Lamar”) against one of its clients, R. Scott Appling. Appling incurred certain legal fees when Lamar represented him in lawsuits against the former owners of his business; however, Appling was unable to pay his legal bills when they became due. During a meeting with attorneys from Lamar, Appling conveyed that he was expecting a substantial tax refund, which he represented would be sufficient to pay his outstanding legal bill as well, as to pay any future fees incurred during the ongoing litigation. In reliance of this statement, Lamar continued its representation of Appling and did not take any steps to immediately collect its overdue fees. However, Appling’s statement was false as he only received a modest refund, which he put into his business rather than to satisfy the outstanding legal fees owed to Lamar. Lamar eventually filed suit against Appling to collect the outstanding fees, and Appling subsequently filed for bankruptcy. The central issue is whether Appling’s oral statements regarding his tax refund, which pertained to a single asset, respected his financial condition and is therefore dischargeable.

The Supreme Court’s decision could have ramifications on the discharge of debts in bankruptcy. The narrower interpretation of the statute favored by the majority of circuits will limit the scope of the “financial condition” exception contained in section 523(a)(2)(B). This “gives effect to the fundamental bankruptcy policy that the bankruptcy courts will not provide safe haven for the perpetuators of fraud.”[3] Indeed, the exception was originally conceived by Congress to address certain consumer-finance companies that were deliberately encouraging customers to submit false statements for the purpose of insulating the creditor’s claim from discharge.[4] However, application of the majority view is difficult in practice because it creates “substantial line-drawing problems and may cause unjustified differential treatment of functionally equivalent scenarios.”[5]

On the other hand, applying the broader interpretation put forth by the Eleventh Circuit could promote predictability and accuracy while protecting debtors from abusive credit practices.[6] It encourages creditors to rely on written statements, which are more reliable as evidence, if they later seek an exemption.[7] The office of U.S. Solicitor General advanced this position and filed a brief as Amici Curiae agreeing with the Eleventh Circuit’s ruling. The Solicitor General argued that the broader interpretation best served Congress’s policy goals because it “gives creditors an incentive to create writings before the fact,” which may reduce fraud in the first instance.[8] By creating reliable evidence for future litigation, “such writing helps both the honest debtor prove his honesty and the innocent creditor prove a debtor’s dishonesty.”[9] Nevertheless, the Eleventh Circuit’s interpretation could expand the exception’s reach beyond its intended scope because “virtually every statement by a debtor that induces the delivery of goods or services on credit relates to his ability to pay.”[10] With the “financial condition” exception taking center stage, this Supreme Court decision will certainly be one to watch.

Last November, the HHR Bankruptcy Report reported on the Supreme Court’s grant of the petition for certiorari in Husky International Electronics, Inc. v. Ritz, a case in which the Fifth Circuit had held that “actual fraud” under section 523(a)(2)(A) of the Bankruptcy Code (which limits the breadth and effect of a debtor’s discharge) required proof of a false representation. Earlier today, in a 7-1 decision, the Supreme Court issued its opinion, reversing the Fifth Circuit’s holding and ruling that actual fraud encompasses “fraudulent conveyance schemes, even when those schemes do not involve a false representation.”

In holding that actual fraud “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation,” the Supreme Court looked to congressional intent and the historical meaning of actual fraud. As to congressional intent, the Court explained that before 1978, the Bankruptcy Code prohibited debtors from discharging a debt obtained by “false pretenses or false representations.” In the Bankruptcy Reform Act of 1978, Congress changed the statute such that a debtor cannot discharge a debt obtained by “false pretense, a false representation, or actual fraud.” As Justice Sotomayor explained, it can be presumed “that Congress did not intend ‘actual fraud’ to mean the same thing as a ‘false representation,’ as the Fifth Circuit’s holding suggests.”

Turning to the historical meaning of actual fraud, the Court began its analysis by quoting the original Elizabethan language of the one of the first bankruptcy statutes, the Statute of 13 Elizabeth, also known as Fraudulent Conveyances Act of 1571, which “identified as fraud ‘feigned convenous and fraudulent Feoffmentes Gyftes Grauntes Alientations [and] Conveyaunces’ made with “Intent to delaye hynder or defraude Creditors.’” The Court noted that the principles behind the 1571 Act, which make it fraudulent to hide assets from creditors by giving them to one’s family or friends, are still used and “embedded in laws related to fraud today.” This, the Court explained, “clarifies that the common-law term ‘actual fraud’ is broad enough to incorporate a fraudulent conveyance.” Further, the fact that, under the 1571 Act and laws that followed, both the debtor and recipient of the assets are liable for fraud, underscores the notion that a “false representation has never been a required element of ‘actual fraud.’”

The Court also rejected the debtor’s argument that the Court’s interpretation would create a redundancy with section 727(a)(2), which prevents a debtor from discharging all debts if, within the year preceding the filing of the petition, the debtor transferred or concealed its assets for the purposes of hindering, delaying, or defrauding a creditor. The Court noted that the two sections may overlap, but that section 727(a)(2) is broader in scope because it prevents an offending debtor from discharging all debt in bankruptcy, and is narrower in timing as it applies only if the debtor fraudulently conveys assets within a year preceding the filing of the petition. Therefore, unlike section 727(a)(2), section 523(a)(2)(A) is tailored as a remedy for behavior connected only to specific debts.

In dissent, Justice Thomas opined that “actual fraud” in section 523(a)(2)(A) “does not apply so expansively” to include fraudulent transfer schemes effectuated without any false representation. Although he agreed with the majority that the common law definition of “actual fraud” included fraudulent transfers, he explained that the general rule that a common law term of art should be given its established common law meaning must give way where the meaning does not fit. Here, according to Justice Thomas, “context dictates” that actual fraud does not include fraudulent transfers because that meaning fails to fit with the rest of section 523(a)(2).

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Hughes Hubbard’s Corporate Reorganization & Bankruptcy group represents companies, creditors and trustees in complex restructurings—both in and out of court—and in the multiple types of litigation that insolvency proceedings generate.

About Hughes Hubbard

Hughes Hubbard & Reed LLP is an international law firm ranked for 12 years on The American Lawyer’s A-List of what the magazine calls “the top firms among the nation’s legal elite.” The firm was founded in 1888 by the renowned jurist and statesman Charles Evans Hughes.